Much Ado About Nothing? Do Domestic Firms Really Benefit - Iza

38 Pages·2003·0.42 MB·English

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IZA DP No. 944
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R Much Ado About Nothing?
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P Do Domestic Firms Really Benefit
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from Foreign Direct Investment?
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O Holger Görg
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David Greenaway
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D November 2003
Forschungsinstitut
zur Zukunft der Arbeit
Institute for the Study
of Labor
Much Ado About Nothing?
Do Domestic Firms Really Benefit
from Foreign Direct Investment?

Holger Görg
GEP, University of Nottingham,
DIW Berlin and IZA Bonn

David Greenaway
GEP, University of Nottingham

Discussion Paper No. 944
November 2003

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IZA Discussion Paper No. 944
November 2003

ABSTRACT

Much Ado About Nothing? Do Domestic Firms Really
∗
Benefit from Foreign Direct Investment?

Governments the world over offer significant inducements to attract inward investment,
motivated by the expectation of spillover benefits to augment the primary benefits of a boost
to national income from new investment. This paper begins by reviewing possible sources of
FDI induced spillovers. It then provides a comprehensive evaluation of the empirical evidence
on productivity, wages and exports spillovers in developing, developed and transitional
economies. Although theory can identify a range of possible spillover channels, robust
empirical support for positive spillovers is, at best, mixed. The reasons for this are explored
and the paper concludes with a review of policy aspects.

JEL Classification: F21, F23

Keywords: foreign direct investment, multinationals, spillovers, productivity, wages,
exports

Corresponding author:

Holger Görg
School of Economics
University of Nottingham
Nottingham NG7 2RD
UK
Tel.: [phone]
Fax: [phone]
Email: [email protected]

∗ Earlier versions of the paper were presented at an UNECE/EBRD meeting in Geneva, an UNECLAC
conference in Mexico City, an IDB/Worldbank conference in Washington DC and a CEPR meeting in
Turin. The authors wish to thank in particular Wolfgang Keller, Bob Lipsey, Mauricio Mesquita Moreira,
Andres Rodríguez-Clare, Ian Wooton, for helpful comments and suggestions. In addition, reports from
four anonymous referees and the Managing Editors of the WBRO were extremely helpful. Financial
support from The Leverhulme Trust under Programme Grant F114/BF and the European Commission
under Grant No. SERD-2002-00077 is gratefully acknowledged.
1. Introduction
Of all the drivers of globalisation - armslength trade, migration of workers and cross
border investment - the last is probably the most visible. This presumably explains
why public anxiety about globalisation often manifests itself as hostility towards
multinationals (see Deardorff 2003 for a recent appraisal of such anxieties). From an
economic standpoint, cross-border investment may also be, at the margin, the most
important manifestation of the globalisation process. Annual flows of FDI now
exceed $700 billion and the total stock exceeds $6 billion. Over the last decade FDI
flows have grown at least twice as fast as trade.
As with armslength trade, the FDI environment is policy distorted, but has been
gradually becoming more liberalised. Thus, in 1998, of 145 regulatory changes made
by 60 countries, 94% created more favourable conditions for FDI (UN 1999). In many
cases intervention has extended beyond creating a more liberal environment, to
providing substantial public subventions. For example, Head (1998) reports that the
Government of Alabama paid the equivalent of $150,000 per employee to Mercedes
for locating its new plant in the state in 1994. Across the Atlantic, the British
Government provided an estimated $30,000 and $50,000 per employee to attract
Samsung and Siemens respectively to the North East of England in the late 1990s
(Girma, Greenaway and Wakelin 2001). Some countries also provide tax incentives.
For example, Ireland offers a corporate tax rate of 10 percent to all manufacturing
firms locating there.
There seems to be a widely held assumption that foreign firms more than ‘pay their
way’ not only do they bring new investment which boosts national income, they are
expected to bring secondary spillovers to the host economy, resulting in productivity
growth, or export growth being higher than otherwise. Much econometric work has
been done in this area that provides, at best, mixed results as to the importance of
spillovers. There is some supportive evidence from case studies of spillover benefits
to domestic firms (e.g., Moran 2001) although there is, even at that level,
disagreement in particular instances.1
The failure to find unambiguously positive effects in econometric work could be due
to (one or more of) a number of factors. First, despite theoretical arguments pointing
to their existence, spillovers may simply be unimportant in reality. In practice, MNEs
may be effective at ensuring firm specific assets and advantages do not spill over. A

1 For example, Larrain, Lopez-Calva and Rodriguez-Claré (2000) conclude that the location of Intel in
Costa Rica has had positive effects on the local economy, Hanson (2000) argues that there is little
evidence for spillovers from Intel on domestic firms. Hanson (2000) also argues that the location of
Ford and General Motors in Brazil have failed to show the expected spillover benefits.
1
second possibility is that spillovers exist and are some part of the ‘residual’ which
appears in all growth equations, but we have simply failed to develop the statistical
methods and/or do not have the datasets to identify them. Furthermore, there may be
much heterogeneity in spillovers and aggregate studies may therefore fail to detect
them. Moreover, the lack of good quality, comprehensive firm/plant level datasets is
a serious impediment to research and it is at this level that we should be searching for
evidence.
This paper examines in detail the evidence for intra-industry productivity spillovers in
both theory and econometric analyses.2 We not only provide an update on earlier
surveys such as Blomström and Kokko (1998) and Lipsey (2002), we also highlight
methodological issues and the scope for policy makers in enhancing potential
spillover effects. Also, the paper is more focussed on spillovers from FDI than related
studies by Keller (2001) or Saggi (2002) who discuss more generally the scope and
evidence for international technology diffusion without going into too much detail on
FDI.
In Section 2 we begin by asking what guidance theory can give, on two counts: first,
what are the possible channels for transmission of spillover benefits; second, are host
country characteristics likely to make a difference to the extent or speed with which
spillovers occur? Section 3 examines the empirical evidence on spillovers in
developed, developing and transitional economies. In Section 4 we focus on policy:
should governments intervene? If so, what policies should they use? Does policy
make any difference? Finally, Section 5 concludes.
2. What Does Theory Tell Us?
2.1 Context
There is a well developed literature which tries to explain why multinational
enterprises (MNEs) set up overseas rather than export directly and/or licence their
product/technology. The most persuasive explanations are those that emphasise the
co-existence of proprietary knowledge of some form and market failures in protecting
that knowledge. Thus the firm internalises certain transactions to protect its
brand/technology/marketing advantages. This literature has been extensively
surveyed (see Caves, 1996 and Markusen, 1995) and we take these motives as given.
In particular, we take as given the existence of some kind of firm specific asset,

2 This paper, thus, takes essentially a microeconomic and microeconometric view on these issues. A
related literature examines the macro effect of inward FDI on growth in the framework of cross-
country growth regressions. See, for example, Balasubramanyam, Salisu and Sapsford (1996),
Borensztein, DeGregorio and Lee (1998) and Alfaro, Chanda, Kalemli-Ozcan and Sayek (2003) for
recent evidence. DeMello (1997) provides a review of that literature.
2
usually some kind of technological advantage.3 The first question is then, having
chosen a particular location how might any advantages spill over to the local economy
via firms in the same industry? Having identified potential transmission channels, we
then need to ascertain whether particular host economy characteristics will make a
specific host more or less likely to benefit from spillovers.
2.2 Spillover Channels
When a firm sets up a plant overseas, or acquires a foreign plant, it does so in the
expectation of realising a higher rate of return than a given domestic firm with an
equivalent investment. The source of the higher return is the technological advantage
alluded to above. Whatever its source, the only way in which indigenous firms can
gain from external benefits is if some form of indirect technology transfer takes place
- MNEs will not hand over the source of their advantage voluntarily. The theoretical
literature identifies four channels through which the host might boost its productivity
via spillovers, as set out in Table 1: imitation; skills acquisition; competition; exports.
[Table 1 here]
Imitation is the classic transmission mechanism for new products and processes. A
mechanism commonly alluded to in the theoretical literature on ‘North-South’
technology transfer is reverse engineering (e.g. Das, 1987; Wang and Blomström,
1992). Its scope depends on product/process complexity, with simple manufactures
and processes easier to imitate than more complex ones. The same principle applies
to managerial/organisational innovations, though in principle, at any rate, these are
easier to imitate. Imitation is, of course, not the same as replication and it would be
surprising if the rents accruing to MNEs were entirely dissipated by the process.
However, any upgrading to local technology deriving from imitation could result in a
spillover, with consequent benefits for the productivity of local firms.
Adoption of new technology can also occur through acquisition of human capital.
Even when the locational pull for MNE investment is relatively low wages they
nevertheless tend to demand relatively skilled labour in the host country. Generally
they will invest in training and in the absence of slavery, it is impossible to lock-in
such resources completely.4 As a result, the movement of labour from MNEs to
existing firms, or to start new firms can generate productivity improvement via two
mechanisms. First, a direct spillover to complementary workers; second, workers that
move may carry with them knowledge of new technology or new management

3 Note that ‘technological advantage’ should be interpreted broadly to include innovative management
and organisational processes as well as new production methods and technologies.
4 It is interesting to note that this inability to protect investment in human capital fully has long been
seen as an argument for infant industry protection as a response to potential first mover disadvantages
(see Baldwin 1968).
3
techniques. Some argue this is the most important channel for spillovers: Haaker
(1999) and Fosfuri, Motta and Ronde (2001), for instance. Moreover, some empirical
work supports this, e.g. Djankov and Hoekmann (1999) and Görg and Strobl (2002a).
Many models emphasise the role of competition (Wang and Blomström, 1992; Glass
and Saggi, 2002). Unless an incoming firm is offered monopoly status, it will
produce in competition with indigenous firms. Even if the latter are unable to imitate
the MNE’s technology/production processes, they are under pressure to use existing
technology more efficiently, yielding productivity gains. Greater competition leading
to a reduction in X-inefficiency is analogous to one of the standard gains from
armslength trade and is frequently identified as one of the major sources of gain.5 In
addition, of course, competition may increase the speed of adoption of new
technology or the speed with which it is imitated.
A further indirect source of productivity gain might be via export spillovers. Crudely,
domestic firms can learn to export from multinationals (see Aitken, Hanson and
Harrison, 1997, Barrios, Görg and Strobl, 2003 and Greenaway, Sousa and Wakelin,
2004). Exporting generally involves fixed costs in the form of establishing
distribution networks, creating transport infrastructure, learning about consumers’
tastes, regulatory arrangements and so on in overseas markets. MNEs will generally
establish already armed with such information and exploit it to export from the new
host. Through collaboration, or more likely imitation, domestic firms can learn how
to penetrate export markets. There is a growing literature that links exporting and
productivity. Recent work for example on Mexico, Morocco and Venezuela, the US,
Spain, Germany and the UK suggests that productivity levels of exporting firms are
higher than non-exporting firms.6
2.3 Host Country Characteristics and Spillovers
The literature on the determinants of FDI emphasises locational characteristics as
important factors in the multinationals’ decisions on where to invest (e.g., Wheeler
and Mody, 1992, Brainard, 1997, Görg, 2002). But this is a different issue entirely,
relating to features of the host economy which attract inward investment in the first
instance. Our focus is the issue of whether there are locational characteristics which
affect the speed of adoption of new technology/ spill over of productivity gains.

5 For instance, the Cecchini Report on the benefits of completing the Single Market in Europe
identified such pro-competitive effects as the single most important source of gain.
6 See Clerides, Lach and Tybout (1998), Bernard and Jensen (1999), Bernard and Wagner (1997),
Delgado, Fariñas and Ruccino (2003) and Girma, Greenaway and Kneller (2004). An issue central to
this literature is whether firms self-select into exporting, or increase their productivity after entering
into export markets. The first three papers stress the self-selection explanation, while the latter two
find some evidence consistent with learning by exporting.
4
A pioneering contribution is Findlay (1978) who emphasised the importance of
relative backwardness and contagion. The former refers to the distance between two
economies in terms of development. Findlay’s model suggests that the greater this
distance, the greater the backlog of available opportunities to exploit in the less
advanced economy, the greater the pressure for change and therefore the more rapidly
new technology is imitated/adopted. Moreover, speed of adoption is also a function of
contagion, or the extent to which the activities of the foreign firm pervades the local
economy. Thus, if the MNE quickly establishes upstream and downstream networks,
technology transfer will be more rapid as a result of domestic firms involved in supply
and distribution chains gaining exposure to and familiarity with new technology and
promoting its diffusion.
Glass and Saggi (1998) also see a role for technological distance between the host and
home country, but a different one to Findlay. Any technology gap signals something
to the MNE about absorptive capacity. The bigger it is, the less likely the host is to
have the human capital, physical infrastructure and distribution networks to support
inward investment. This influences not only the decision to invest but also what kind
of technology to transfer. Specifically, the bigger the gap the lower the quality of
technology transferred and the lower the potential for spillovers. This seems more
plausible than Findlay's notion of a lack of absorptive capacity as the driver. Clearly
technological distance will be directly related to the potential gains from spillovers
but it is also likely to be inversely related to the probability that indigenous firms are
actually able to access them.
2.4 Summary
Economic theory gives some guidance in terms of what to expect where cross-border
investment and spillovers are concerned. In general, MNEs have firm specific
advantages which might be related to the production methods they use, the way they
organise their activities, the way they market their products/services and so on. Once
they have set up a subsidiary, they may be unable to prevent some of the benefits of
these advantages from spilling over to indigenous firms via imitation, labour mobility,
competition or local firms learning to export. Such spillovers have the potential to
raise productivity and their exploitation might be related to the structural
characteristics of the host economy, in particular absorptive capacity.
5
3. What Does the Evidence Tell Us?
3.1 Overview
The empirical literature was pioneered by Caves (1974), Globerman (1979) and
Blomström (1986) using data for Australia, Canada and Mexico, respectively. Since
then, their empirical models have been extended and refined although the basic
approach is still, by and large, similar. Most econometric analyses are undertaken in a
framework in which labour productivity or total factor productivity of domestic firms
is regressed on a range of independent variables. To measure productivity spillovers
from multinationals a variable is included which proxies the extent of foreign firms’
penetration, usually calculated as the share of employment or sales in multinationals
over total industry employment/sales in a given sector.7 In other words, the
regression allows for an effect of FDI on productivity of domestic firms in the same
industry. If the regression analysis yields a positive and statistically significant
coefficient on the foreign presence variable, this is taken as evidence that spillovers
have occurred from MNEs to domestic firms.8 Most studies use either the
contemporaneous level of foreign penetration, or relatively short lags (most
commonly a one year lag) as their explanatory variables. If anything therefore, these
studies usually measure short run effects of foreign presence on domestic
productivity.
[Table 2 here]
Table 2 sets out details of 40 studies of horizontal productivity spillovers in
manufacturing industries in developing, developed and transition economies.9 Of
those, 19 report statistically significant and positive horizontal spillover effects. Note,
however, that all but eight of those reporting positive spillovers use cross sectional
data which may lead to biased results, as argued by Görg and Strobl (2001). They
argue that panels, using firm level data are the most appropriate estimating framework
for two reasons. Firstly, panel data studies allow us to investigate the development of

7 In a recent paper, Castellani and Zanfei (2002a) argue that one should use the absolute level of
foreign activity in the sector, rather than the proportion of foreign relative to total activity, since using
a ratio imposes the restriction that changes of the same magnitude in foreign and aggregate activities
within a sector have no effect on the dependent variable. While this is an interesting (econometric)
argument it is not clear what the economic rationale for using absolute rather than relative FDI
penetration would be.
8 The interpretation of this coefficient of course hinges on the assumption that the FDI variable does
not merely pick up the effect of other correlated factors on productivity, i.e., we need to assume that
there is a full vector of productivity augmenting activities included in the empirical model. While this
may be problematic in some of the studies reviewed herein, it is beyond the scope of this paper to
discuss this in detail and we, therefore, assume in the remainder of the paper that the estimated FDI
coefficient adequately reflects spillovers.
9 Given the surge in papers on productivity spillovers recently it is possible that this survey misses out
on a few recent papers, which are not published yet.
6
domestic firms' productivity over a longer time period, rather than relying on one data
point. Secondly, they allow us to investigate spillovers after controlling for other
factors. Cross sectional data, in particular if they are aggregated at the sectoral level,
fail to control for time-invariant differences in productivity across sectors which
might be correlated with, but not caused by, foreign presence. Thus coefficients on
cross-section estimates are likely to be biased. For example, if productivity in the
electronics sector is higher than, say, the food sector, multinationals may be attracted
into the former. In a cross section, one would find a positive and statistically
significant relationship between the level of foreign investment and productivity,
consistent with spillovers, even though foreign investment did not cause high levels of
productivity but rather was attracted by them.
Taking this into consideration, the evidence on positive horizontal spillovers is much
weaker. There are only seven papers employing panel data which find some positive
evidence in the aggregate, none of which is for developing countries: Liu, Siler,
Wang and Wei (2000) and Haskel, Pereira and Slaughter (2002) for the UK,
Castellani and Zanfei (2002) for Italy, Keller and Yeaple (2003) for the US, Ruane
and Ugur (2002), Görg and Strobl (2003) for Ireland and Damijan et al. (2001) for
Romania. Liu et al., however, use industry level data that aggregates over
heterogeneous firms, which may lead to biased results.10 This leaves only six studies
using appropriate data and estimation techniques which report positive evidence for
aggregate spillovers.
For example, the papers by Aitken and Harrison (1999), Castellani and Zanfei (2002),
Djankov and Hoekman (2000), Konings (2001), Zukowska-Gagelmann (2002) and
Damijan et al. (2001) find some evidence of negative effects of the presence of
multinationals on domestic firms in the aggregate. These papers use firm level panel
data for manufacturing industries in Venezuela, Spain, the Czech Republic, Bulgaria,
and Romania, Poland and seven CEE countries respectively. It is interesting to note
that many studies for transition economies find at least some evidence of negative
results. Fifteen of the studies do not find any statistically significant effects, on
average, of multinationals on domestic productivity.11

10 This has been pointed out by, for example, Dunne, Roberts and Samuelson (1989) for the case of
measuring the growth performance of manufacturing plants in the US.
11 The magnitude of the coefficients, which indicates the strengths of the spillovers, also differs across
studies. Görg and Strobl (2001) attempt to explain the differences in magnitude in a meta-regression
analysis, using characteristics of the studies (data, variables used, countries covered, etc.) as
explanatory variables.
7